In the case of Dunn v. Commissioner, TC Memo 2022-112,[1] the taxpayers lost deductions for claimed depreciation on an automobile and losses from a partnership they wholly owned that held real estate.

Facts of the Case

The opinion begins by describing the LLC taxed as a partnership held by Heather and Edison Dunn:

Petitioners formed Magnet Development, LLC (Magnet), in February 2007 to manage investments in real estate. On March 14, 2008, Magnet purchased a 21-unit apartment building in Hephzibah, Georgia (Hephzibah building). Petitioners lived approximately 150 miles from the Hephzibah building. To assist in managing the Hephzibah building Magnet employed Ebony Calhoun from January 5 to July 27, 2013, to collect rents, show apartments, and clean vacant apartments. In addition Magnet hired Augusta Partners Property Management, LLC (Augusta Partners), to rent, lease, operate, and manage the Hephzibah building pursuant to a contract with an effective date of January 2, 2014. Petitioners owned additional properties in Athens and Snellville, Georgia, in their individual names and which they managed on their own.

…

Petitioners each owned 50% of Magnet, which was treated as a non-TEFRA partnership for federal income tax purposes. Magnet timely filed Forms 1065, U.S. Return of Partnership Income, for the years in issue. Magnet reported income and claimed expense deductions for the Athens and Snellville properties on its Forms 8825, Rental Real Estate Income and Expenses of a Partnership or an S Corporation. It [*3] also claimed depreciation deductions at 100% business use of a 2013 Ford Explorer that petitioner wife purchased in May 2013. It reported net losses for both years in issue.[2]

The Court noted that the taxpayers, despite each having full-time employment, were arguing they were real estate professionals:

During the years in issue petitioner husband was employed as a full-time technology support specialist with Gwinnett County Public Schools, and petitioner wife was employed as a full-time computer specialist with Huron Consulting Services, LLC. In addition they attempted to work as full-time real estate professionals. In order to substantiate their real estate activities, petitioners kept two separate logs with respect to the hours they claim to have spent working on the Hephzibah building, the Athens property, and the Snellville property in 2013 and 2014. One log relates to activity conducted at the Hephzibah building in 2014. This log provides the date along with a two- or three-word description of the job completed; it does not list the hours spent working. The second log relates to activity conducted at all three properties in 2013 and 2014. This log provides the date, name of the property, hours worked, and a vague description of the work performed; it does not specify the tasks each petitioner individually performed.[3]

The couple claimed the entire amount of losses reported by the partnership on their individual income tax returns:

Petitioners filed a joint individual income tax return for each year in issue; however, they did not make an election to group their rental real estate activities as one activity for purposes of section 469(c)(7)(A) for either year. They claimed flowthrough losses from Magnet of $85,260 and $48,740 for taxable years 2013 and 2014, respectively. Petitioners also claimed a loss deduction of $7,028 on their Schedule E, Supplemental Income and Loss, for 2014.[4]

The IRS examined the taxpayers’ return and, as you might expect given these facts, asserted the taxpayers had claimed losses they were not entitled to:

On June 8, 2016, the examiner's group manager signed a Civil Penalty Approval Form with respect to the examination of Magnet approving accuracy-related penalties pursuant to section 6662(a) on the individual shareholders' returns for 2013 and 2014. On September 19, 2016, the group manager signed a second Civil Penalty Approval Form approving accuracy-related penalties against petitioners for the same period. On February 1, 2017, respondent issued petitioners a notice of deficiency for the years in issue.[5]

Automobile Expenses Had a Number of Problems

The Court first deals with the automobile depreciation deduction claimed on the partnership return.  The Court notes:

For property used in a trade or business or held for the production of income, a depreciation deduction is allowed for reasonable exhaustion or wear and tear. § 167(a). Magnet claimed depreciation deductions for petitioner wife's Ford Explorer for the years in issue.[6]

The opinion immediately comments on the fact that the partnership did not actually own the vehicle in question:

Petitioners failed to explain why Magnet should be entitled to deductions for property it did not own.[7]

The Court notes that detailed documentation requirements apply to any claimed deduction for vehicles:

To substantiate entitlement to a depreciation deduction, a taxpayer must establish the property's depreciable basis by showing the cost of the property, its useful life, and the previously allowed depreciation. Cluck v. Commissioner, 105 T.C. 324, 337 (1995). To be entitled to a deduction for an automobile, a taxpayer must establish that the automobile was used at least partially for business, and the deductions will be allowed only to the extent of its business use. In addition, a claimed deduction with respect to any “listed property” — a category including “any passenger automobile” — is subject to the heightened substantiation requirements under section 274(d). See § 280F(d)(4) (defining “listed property”).[8]

The Court concludes that the taxpayers didn’t come close to substantiating the claimed depreciation:

Petitioners failed to substantiate the cost of the Ford Explorer, when it was placed in service, the business percentage use of the vehicle, and the previously allowed depreciation. Accordingly, we sustain the disallowance of a deduction for depreciation for both 2013 and 2014.[9]

Partnership Didn’t Own Two Properties

The Ford Explorer wasn’t the only item that the couple attempted to report on the partnership return that wasn’t owned by the partnership.  As the Court noted:

For 2013 and 2014 Magnet reported income, expenses, and resulting losses of $3,662 and $5,100 for 2013 and 2014, respectively, for the properties in Athens and Snellville. However, petitioners owned these properties in their individual capacities, not Magnet. Petitioners did not provide any evidence to show that Magnet was entitled to deduct these losses. Accordingly, petitioners are not entitled to deduct them as flowthrough losses.[10]

In a footnote the Court noted the taxpayers failed to argue that, if the properties weren’t partnership property, they should be able to report the loss on their own return—and why it wouldn’t have mattered if they had made that argument:

Nor have petitioners claimed that they should be allowed to deduct Schedule E losses in those amounts; and even if they had, for the reasons set forth below they would not be entitled to them.[11]

Lack of Documentation of Basis for Partnership Interests

Things don’t get better for the taxpayers when the Court turns to the partnership losses. The Court begins by noting that no losses could have been allowed, regardless of other issues the Court will discuss, because the taxpayers provided no evidence of their basis in their partnership interests:

Pursuant to section 704(d) “[a] partner’s distributive share of partnership loss (including capital loss) shall be allowed only to the extent of the adjusted basis of such partner’s interest in the partnership at the end of the partnership year in which such loss occurred.” Petitioners formed Magnet on February 8, 2007, and they provided no evidence showing their basis for 2013 or 2014. Because there is no evidence of petitioners’ adjusted bases, they are not entitled to deduct losses from Magnet for 2013 and 2014.[12]

Also Missing Documentation of At Risk Amount

The Court continued pointing out the many ways the taxpayers were going to be unable to claim any losses, this time pointing out that they did not show they had enough at risk to claim any losses from the partnership.

Pursuant to section 465(a) taxpayers are entitled to losses from rental real estate only to the extent of the aggregate amount with respect to which the taxpayer is at risk for such activity at the close of the year. Amounts considered at risk include (1) the amount of money and the adjusted basis of other property contributed by the taxpayer to the activity and (2) borrowed funds that the taxpayer is personally liable for or has pledged property for the borrowed amount. § 465(b). Petitioners failed to show that any amounts in respect of their rental real estate activities were at risk.[13]

Passive Activity Loss Problem

The final area the Tax Court decision looks at that would also deny any deduction relates to the passive loss rules of IRC §469.

The opinion first provides the basic rules applicable to passive activities:

Taxpayers may deduct costs for certain business and investment expenses under section 162. If the taxpayer is an individual, section 469 generally disallows any passive activity loss deduction for the taxable year and treats it as a deduction or credit for the next taxable year. § 469(a) and (b). A passive activity loss is defined as the excess of the aggregate losses from all passive activities for the taxable year over the aggregate income from all passive activities for that year. § 469(d)(1).

A passive activity is any trade or business in which the taxpayer does not materially participate. § 469(c)(1). A taxpayer is treated as materially participating in an activity only if his or her involvement in the operations of the activity is regular, continuous, and substantial. § 469(h)(1).[14]

The opinion then notes that, under the law, a rental activity generally is considered a passive activity:

Rental activity is generally treated as a per se passive activity regardless of whether the taxpayer materially participates. § 469(c)(2). A taxpayer who actively participates in a rental real estate activity can deduct a maximum loss of up to $25,000 per year (subject to phaseout limitations) related to the activity. § 469(i)(1)–(3).[15]

However, a provision enacted after the Tax Reform Act of 1986 brought the passive activity rules into the law carved out an exception to this default passive treatment for a taxpayer who qualifies as a real estate professional:

Section 469(c)(7) provides an exception to the general rule that a rental activity is per se passive. The rental activities of a taxpayer in a real property trade or business (a real estate professional) are not subject to the per se rule of section 469(c)(2). § 469(c)(7); see Kosonen v. Commissioner, T.C. Memo. 2000-107, slip op. at 9; Treas. Reg. § 1.469-9(b)(6), (c)(1).[16]

To be a real estate professional, the taxpayer must satisfy two tests for the tax year:

A taxpayer qualifies as a real estate professional if: (1) more than one-half of the personal services performed in trades and businesses by the taxpayer during the taxable year are performed in real property trades or businesses in which the taxpayer materially participates and (2) the taxpayer performs more than 750 hours of services during the taxable year in real property trades or businesses in which the taxpayer materially participates. § 469(c)(7)(B). Section 469(c)(7)(C) provides that “the term 'real property trade or business' means any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.” In the case of a joint return the above requirements are satisfied if either spouse separately satisfied these requirements. § 469(c)(7)(B)[17]

But being a real estate professional by itself does not make a taxpayers’ rental real estate activities nonpassive.  Rather, the taxpayer now is permitted to show material participation and only then will the activity or activities be treated as non-passive:

Rather, the rental activities of a real estate professional are subject to the material participation requirements of section 469(c)(1). See Treas. Reg. § 1.469-9(e)(1).[18]

A taxpayer thus must meet the requirements to show material participation in the activity or activities to be able to treat the losses as not subject to the §469 limits:

A taxpayer is considered to have materially participated in an activity if one of the seven tests listed in the regulations is satisfied. Temp. Treas. Reg. § 1.469-5T(a). A taxpayer may establish hours of participation by any reasonable means. Id. para. (f)(4). Contemporaneous daily reports are not required if the taxpayer can establish participation by other reasonable means. Id. Reasonable means include “appointment books, calendars, or narrative summaries” that identify the services performed and “the approximate number of hours spent performing such services.” Id. We have noted previously that we are not required to accept a postevent “ballpark guesstimate” or the unverified, undocumented testimony of taxpayers. See, e.g., Moss v. Commissioner, 135 T.C. 365, 369 (2010).[19]

For a married couple filing a joint return, the hours tests are different for qualifying as materially participating in the activity vs. qualifying as a real estate professional:

If a taxpayer is married, activity by the taxpayer’s spouse counts in determining “material participation” by the taxpayer. See § 469(h)(5); Temp. Treas. Reg. § 1.469-5T(f)(3). Spousal attribution may not be used for the purpose of satisfying the 750-hour annual service requirement. See Oderio v. Commissioner, T.C. Memo. 2014-39, at *6.[20]

The Court then takes note of the records the taxpayers did present to document the hours they had been involved in the rentals:

In 2013 and 2014 both petitioners worked full-time jobs unrelated to real estate. They provided logs that purported to show their collective rental real estate activities during that time. The logs show 767 hours worked in 2013 and 407 hours worked in 2014; however, the logs do not specify which petitioner worked these hours. Moreover, the hours recorded in the logs are inflated because petitioners included not only hours spent performing activities related to rental real estate, but also the hours they spent physically present at the properties.[21]

The Court first points out that the taxpayers had failed to show either of them had met the requirements to be a real estate professional for either year:

Petitioners contend that they both spent more than one-half of the personal services they performed in a trade or business in a real property trades or business. We disagree. Both petitioners had full-time jobs unrelated to real estate. The evidence does not support the conclusion that half of their time was spent performing services in real property trades or businesses.

Petitioners further contend that they met the 750-hour requirement. To meet this requirement only one spouse needs to have reached the 750-hour mark. See § 469(c)(7)(B). Petitioners have not shown that either of them met the material participation requirements; therefore, neither petitioner qualifies as a real estate professional.[22]

The Court also notes that the taxpayers did not show material participation in their rental activities.  By failing to make the election to treat all rentals as a single activity, the taxpayers were faced with showing material participation separately for each rental:

A taxpayer’s material participation in a rental real estate activity is considered separately with respect to each rental property unless the taxpayer makes an election to treat all interests in rental real estate as a single rental real estate activity. § 469(c)(7)(A); Treas. Reg. § 1.469-9(e)(1). A taxpayer makes the election by “filing a statement with the taxpayer’s original income tax return for the taxable year.” Treas. Reg. § 1.469-9(g)(3). There is no evidence that petitioners made an election for either 2013 or 2014 to treat all their rental real estate activities as one activity.[23]

The Court then points out that the taxpayers had not met the requirements that would have been necessary to show material participation in their rental activities:

Nor have they shown that they met one of the seven requirements of Temporary Treasury Regulation § 1.469-5T(a). The logs provide vague and misleading estimates of time spent on the rental properties. We cannot conclude from the logs that either petitioner performed more than 500 hours during the taxable year and that their participation in the activities was not less than the participation of any other individual (including individuals who are not owners of interests in the activities) for such year. See id. subpara. (1). Even if we were to find that petitioners met the 100-hour requirement described in Temporary Treasury Regulation § 1.469-5T(a)(3), they have not shown that either Ms. Calhoun or Augusta Partners worked less than 100 hours.[24]

[1] Dunn v. Commissioner, TC Memo 2022-112, November 29, 2022, https://www.taxnotes.com/research/federal/court-documents/court-opinions-and-orders/couple-liable-for-penalties%3b-deductions-disallowed/7ff38 (retrieved December 3, 2022)

[2] Dunn v. Commissioner, TC Memo 2022-112, November 29, 2022

[3] Dunn v. Commissioner, TC Memo 2022-112, November 29, 2022

[4] Dunn v. Commissioner, TC Memo 2022-112, November 29, 2022

[5] Dunn v. Commissioner, TC Memo 2022-112, November 29, 2022

[6] Dunn v. Commissioner, TC Memo 2022-112, November 29, 2022

[7] Dunn v. Commissioner, TC Memo 2022-112, November 29, 2022

[8] Dunn v. Commissioner, TC Memo 2022-112, November 29, 2022

[9] Dunn v. Commissioner, TC Memo 2022-112, November 29, 2022

[10] Dunn v. Commissioner, TC Memo 2022-112, November 29, 2022

[11] Dunn v. Commissioner, TC Memo 2022-112, November 29, 2022

[12] Dunn v. Commissioner, TC Memo 2022-112, November 29, 2022

[13] Dunn v. Commissioner, TC Memo 2022-112, November 29, 2022

[14] Dunn v. Commissioner, TC Memo 2022-112, November 29, 2022

[15] Dunn v. Commissioner, TC Memo 2022-112, November 29, 2022

[16] Dunn v. Commissioner, TC Memo 2022-112, November 29, 2022

[17] Dunn v. Commissioner, TC Memo 2022-112, November 29, 2022

[18] Dunn v. Commissioner, TC Memo 2022-112, November 29, 2022

[19] Dunn v. Commissioner, TC Memo 2022-112, November 29, 2022

[20] Dunn v. Commissioner, TC Memo 2022-112, November 29, 2022

[21] Dunn v. Commissioner, TC Memo 2022-112, November 29, 2022

[22] Dunn v. Commissioner, TC Memo 2022-112, November 29, 2022

[23] Dunn v. Commissioner, TC Memo 2022-112, November 29, 2022

[24] Dunn v. Commissioner, TC Memo 2022-112, November 29, 2022